Section 163(j) Business Interest Limitation: OBBBA Planning Guide for CPAs

The One Big Beautiful Bill Act (OBBBA) made two significant changes to the Section 163(j) business interest limitation: it permanently restored the more favorable EBITDA-based adjusted taxable income (ATI) calculation starting in 2025, and it closed a common planning workaround — elective capitalization of interest — beginning in 2026. For CPAs advising leveraged businesses, real estate investors, and capital-intensive clients, these changes require updated modeling and, in some cases, a rethinking of debt structure.

What Section 163(j) Does

IRC §163(j) limits the deductibility of business interest expense (BIE) to the sum of:

1. Business interest income (BII) — interest income from business activities
2. Floor plan financing interest — for auto and equipment dealers
3. 30% of adjusted taxable income (ATI) — the earnings-based cap

Any business interest expense that exceeds this limit is disallowed in the current year and carried forward indefinitely. The carryforward retains its character as business interest expense and can be deducted in future years subject to the same 30% limit.

The limitation applies to any taxpayer (individual, partnership, S-Corp, C-Corp) with business interest expense — subject to the small business exception below.

The ATI Calculation: EBITDA Is Back

The most important number in the §163(j) analysis is ATI, because the 30% cap is applied against it. Pre-OBBBA history matters here:

• 2018–2021 (TCJA): ATI was calculated using an EBITDA approach — taxable income was adjusted upward by adding back depreciation, amortization, and depletion. This produced a higher ATI and therefore a higher interest deduction cap.
• 2022–2024: The TCJA's EBITDA phase-out took effect. ATI became an EBIT figure — no D&A addback. For capital-intensive businesses, ATI dropped significantly, trapping more interest in carryforward.
• 2025 and beyond (OBBBA): The EBITDA-based calculation is permanently restored for tax years beginning after December 31, 2024. Depreciation, amortization, and depletion are once again added back when computing ATI.

The practical effect: a manufacturer with $5M of depreciation that was previously excluded from ATI can now include that $5M in the ATI base, potentially allowing an additional $1.5M of interest to be deducted in the current year (30% × $5M).

Businesses that accumulated §163(j) carryforwards during the EBIT years (2022–2024) can now utilize those carryforwards faster under the expanded ATI base.

The New Capitalized Interest Rule (Effective 2026)

For tax years beginning after December 31, 2025 — that is, calendar year 2026 and beyond — the OBBBA closed a pre-existing planning strategy:

Old rule: A taxpayer could elect to capitalize interest to property (e.g., inventory, self-constructed assets, real property under construction) under IRC §263A. Once capitalized, the interest lost its character as "interest" and was no longer subject to the §163(j) limitation. Instead, it became part of the property's basis and flowed through as depreciation or cost of goods sold.

New rule: Any interest that is electively capitalized under §263A retains its character as interest expense and remains subject to the §163(j) limitation. The capitalization election no longer sidesteps the cap.

CPAs who have been using elective capitalization as a §163(j) avoidance strategy — particularly for construction companies, real estate developers, and manufacturers with long production periods — need to revisit their approach for 2026 returns. The alternative: model whether the EBITDA addback restoration under OBBBA already provides sufficient ATI headroom to deduct the interest directly, making elective capitalization less necessary from a tax perspective anyway.

Small Business Exception

Businesses with average annual gross receipts of $31 million or less (indexed for inflation; the 2026 threshold) are exempt from §163(j) entirely under the small business exception of §163(j)(3). These taxpayers can deduct business interest expense in full without limitation.

The $31M threshold is applied using the three-prior-year average gross receipts test of IRC §448(c). Related party aggregation rules apply — businesses under common control are aggregated for this test.

The Real Estate Election

Real property trades or businesses — including rental activities that do not meet the real estate professional standard — can make an irrevocable election under §163(j)(7) to opt out of the business interest limitation entirely. However, the election comes with a cost: electing real property businesses must use the Alternative Depreciation System (ADS) for their residential rental property (30-year ADS life vs. 27.5-year MACRS), nonresidential real property (40-year ADS), and qualified improvement property (20-year ADS instead of 15-year MACRS with bonus depreciation eligibility).

The tradeoff analysis has shifted under OBBBA:

• Before OBBBA, the EBIT-based ATI meant more interest was trapped for real estate businesses. The election was often worth taking even at the cost of ADS depreciation.
• After OBBBA, the EBITDA restoration means real estate businesses get a higher ATI base. For some clients, the election may no longer be necessary — they can fully deduct interest under the 30% cap without switching to ADS. This should be modeled annually.

Clients who already made the election in prior years cannot revoke it. But new clients or new entities should be evaluated under the 2025+ EBITDA framework before making an irrevocable election.

For context on how the real estate professional classification interacts with these passive activity rules, see our guide to real estate professional classification under IRC §469.

Partnership and S-Corp Carryforward Mechanics

The §163(j) carryforward rules differ by entity type — a point that affects both planning and compliance:

Partnerships: Disallowed BIE is not carried forward at the entity level. Instead, it is allocated to partners as excess business interest expense (EBIE) on Schedule K-1 (Box 13, Code K). Each partner tracks their EBIE and can deduct it in future years when the partnership allocates sufficient excess taxable income (ETI) back to that partner. If a partner disposes of their partnership interest, any remaining EBIE is treated as a deduction in the year of sale — but it may be subject to basis limitations.

S-Corporations: Disallowed BIE does carry forward at the entity level, not the shareholder level. The S-Corp deducts it in a subsequent year when ATI is sufficient. Shareholders do not track EBIE individually. This means that for S-Corps, the carryforward is not lost when shareholders change — it stays with the entity.

C-Corporations: Like S-Corps, the carryforward stays at the entity level indefinitely.

The partnership vs. S-Corp distinction matters in practice: for a real estate partnership where some partners may exit, ensuring they can utilize their EBIE before disposition is a planning consideration. See our guide to the passive activity loss rules for how these basis-level constraints interact with PAL limitations.

Rev. Proc. 2026-17: Retroactive Election Relief

Rev. Proc. 2026-17, released in March 2026, provides an opportunity for certain taxpayers to change their §163(j) and §168(k) methods for prior years on an automatic basis. Taxpayers who capitalized interest under the old rules in 2022–2024 — when the EBIT-based calculation made elective capitalization more attractive — may be able to retroactively revise their treatment.

CPAs should review whether prior-year method changes under Rev. Proc. 2026-17 could unlock additional deductions or correct positions taken under planning strategies that the OBBBA has now rendered suboptimal.

International Tax Dimension

For businesses with controlled foreign corporations (CFCs), the OBBBA made an additional change: Subpart F income, GILTI, and IRC §78 gross-ups are excluded from ATI. Previously, these items were included in ATI, providing an earnings base to absorb additional interest deductions.

For multinational businesses or closely held companies with offshore operations, this change may reduce ATI — partially offsetting the EBITDA restoration benefit. The net effect must be modeled on a client-by-client basis.

Planning Checklist for CPAs

Immediate (2025 returns):

• Recompute ATI using EBITDA addback for all leveraged business clients — many will discover additional deductible interest or accelerated carryforward utilization
• Identify clients with §163(j) carryforward from 2022–2024 EBIT years and project when they can be absorbed
• Evaluate the real estate election for new entities: does EBITDA restoration eliminate the need to make an irrevocable ADS election?

Planning for 2026:

• Advise construction, real estate developer, and manufacturer clients to stop relying on elective §263A capitalization as a §163(j) workaround — the strategy is closed
• Model whether direct deduction under the 30% ATI cap (enhanced by EBITDA addback) produces better results than capitalization
• Audit partnership Schedule K-1 reporting for EBIE — confirm partners are tracking carryforwards at the individual level
• Review debt covenant definitions: many loan agreements define available cash flows using EBITDA; ensure tax EBITDA calculations align with covenant calculations

Entity structure:

• For clients choosing between partnership and S-Corp: the entity-level vs. partner-level carryforward distinction is now a concrete planning factor, especially for real estate partnerships with anticipated partner turnover
• For clients with excess §163(j) carryforwards inside a partnership: assess whether disposition of the interest would trigger deductibility of EBIE before it is exhausted

Cost segregation and depreciation strategy:

• A cost segregation study increases total depreciation, which increases ATI under the EBITDA-based formula — creating more room to deduct interest. The two strategies now work together. See our cost segregation guide and Section 179 deduction guide for related planning.

How §163(j) Interacts with Other Limitations

Section 163(j) is one of three overlapping tax limitations on business deductions that CPAs must track simultaneously for pass-through entity clients:

• Excess Business Loss (§461(l)): Limits aggregate business losses for non-corporate taxpayers. The EBL threshold for 2026 is $256,000 (single) / $512,000 (MFJ). Losses that exceed the threshold are converted to an NOL carryforward.
• Net Operating Loss (§172): EBIE that flows through an EBL and becomes an NOL carryforward is then subject to the 80% taxable income limitation.
• §163(j): Applies first, before EBL or NOL, at the entity level for S-Corps and C-Corps and at the partner level for partnerships.

When all three limitations apply, the interaction sequence matters for projecting when a client can actually use their losses.

FAQ

What is the 2026 ATI calculation under §163(j)?

ATI is computed starting from taxable income, then adding back business interest expense, net operating losses, any §199A deduction, and — under OBBBA for 2026 — depreciation, amortization, and depletion. The 30% limit is applied to this adjusted figure. The result determines the maximum business interest expense deductible in the current year.

Can a real estate LLC taxed as an S-Corp elect out of §163(j)?

Yes. A real estate business operating as an S-Corp can make the §163(j)(7) election. The election is made on the S-Corp's return and is irrevocable. The tradeoff is that the entity must use ADS depreciation for its real property holdings, eliminating bonus depreciation eligibility for qualified improvement property and extending MACRS recovery periods.

What happens to §163(j) carryforwards when a partnership interest is sold?

When a partner disposes of their full interest, any remaining EBIE allocated to that partner is treated as a deduction in the year of disposition, subject to basis limitations. If the partner's basis is insufficient to absorb the EBIE, some may be permanently lost. CPAs should project EBIE absorption before advising on a sale timeline.

Does the small business exception cover gross receipts from passive investments?

The gross receipts test under §448(c) generally includes all receipts from business activities but applies to trades or businesses — pure passive investment income from non-trade activities is not included. However, rental income is included when the taxpayer is in the real property trade or business. Related party aggregation rules can pull in receipts from affiliated entities.

How does the capitalized interest change affect construction companies in 2026?

Construction companies that previously capitalized interest to contracts or self-constructed assets under §263A as a §163(j) avoidance strategy must stop doing so for 2026 returns. The capitalized interest retains its character as interest and is subject to the limitation. For most construction clients, the best alternative is to model whether the EBITDA-enhanced ATI produces sufficient deductibility without capitalization — many will find the ordinary deduction approach produces equal or better results under the restored formula.

Where can CPAs find IRS guidance on the OBBBA §163(j) changes?

The primary guidance is IRS Notice 2026-11 (bonus depreciation/§168(k)) and Rev. Proc. 2026-17 (retroactive method change relief for §163(j) and §168(k)). Treasury has indicated that comprehensive proposed regulations addressing the OBBBA §163(j) changes are expected later in 2026.

Arvori helps CPAs streamline client advisory workflows. For more on OBBBA planning strategies, see our guides to the excess business loss limitation, passive activity loss rules, and real estate professional classification.